New Year's Rally Fizzles on Limp Data and
Earnings

FOR TWO WEEKS on Wall Street, ignorance was bliss. But last week the evidence ran amiss.

Investors met the New Year with hopes that the economy was righting itself, corporate profits were poised to ramp higher and the geopolitical threats could be resolved rapidly. These articles of faith drove stocks upward for one of their best January debuts in history, led by the technology stocks that best measure investors' willingness to believe.

Last week, however, some hard numbers and harsh talk put the market's faith to the test, triggering a broad retreat in stock prices.

The advent of earnings-report season brought decent results for a tough fourth quarter, but companies were downbeat in assessing the coming year, depleting investor confidence in the amplitude of the expected profit rebound. Economic data fell limp, with unanticipated declines in consumer sentiment and industrial production and an unforeseen expansion in the U.S. trade deficit. And, outside the Wall Street cocoon, weapons inspectors found suspicious warheads in Iraq, heightening the perceived risk of early military action.

Intel's plan to trim its capital-spending budget for 2003 redounded on the rest of the computer-hardware universe. The Philadelphia semiconductor index, which soared 80% from the October bottom through November and was up 17% the first seven trading days of 2003, lost more than 12% last week, no doubt fracturing the confidence of the tech-revival camp.

The Dow Jones Industrial Average slid 198 points, or 2.2%, to settle at 8586, while the Standard & Poor's 500 lost 25 points, or 2.8%, to reach 901. The week's declines put the broader market represented by the S&P 500 up 2.5% so far this year.

The week's selloff, at least some of which was fueled by profit harvesting after the quick run higher, nonetheless exposed some of the beliefs held by a preponderance of professional investors. John Roque, a technical strategist at Natexis Bleichroeder, says, "My take is that everyone wants to believe that if not for Iraq, things would be fine. And that fiscal and monetary policy will save the day and that oil prices will come down" after a speedy resolution of the Iraq crisis.

In each of these elements of consensus thinking, Wall Street found itself leaning in the wrong direction last week. Oil prices surged above $33 a barrel on supply constraints related to Venezuela's national strike and the requisite unease tied to a potential war in Iraq. The dollar was blasted, reaching $1.07 against the European currency thanks to the war prospects and the trade-imbalance figures. There remains a week until the U.N. weapons inspectors will give a report on their findings, meaning the unfortunate war vigil will continue.

For sure, there's plenty of earnings season left to sway the fundamental data in a more positive direction, though it will take some pretty strong pronouncements to act as counter-weight to the evident caution of
General Electric,
Intel, Microsoft and
IBM.
The limited sample of fourth-quarter earnings that are in have been fine relative to published estimates, with 64% beating forecasts through Thursday, 22% meeting them and 14% falling short. But the way stocks had rallied coming into last week indicated the market was pricing in high hopes for 2003, never mind last year. Reassurance on the future has been meager.

Still, fund managers might be expected some time soon to seek a chance to pick up stocks on pullbacks in a bid to catch up to the market benchmarks, which left the pros in the dust out of the gate this year. Through Thursday, the average actively managed stock mutual fund was already trailing the S&P 500 return -- then up 4.03% year to date including dividends -- by more than 0.6%. That's a big deficit so early in the year.

One of the challenges these professionals face daily is how aggressive or defensive to be in their security selection. It's a tough choice after three years when the meek inherited all the earthly profits to be had. In fact, bright and principled professionals can't agree even on how much risk is presently priced into the markets.

In one of the more intriguing divergences of opinion, the strategists at Merrill Lynch and Morgan Stanley are simultaneously arguing that investors are either perversely paying up to take on more risk (Merrill's Richard Bernstein) or are short-sightedly shunning acceptable equity risk (Morgan's Steve Galbraith).

Bernstein bases his cautious market view on what he sees as the speculative tone to trading, the higher valuations of low-quality stocks versus high ones, complacency about geopolitical threats and earnings quality. Galbraith focuses on the risk aversion embedded in historically low Treasury yields and the historically rare fact that stocks' free cash flow yields now exceed those of 10-year government bonds. Galbraith also believes the gaping inaccuracy of earnings forecasts last year won't be repeated, removing some uncertainty.

Such are the varied views that make markets. Yet it's noteworthy that Bernstein and Galbraith generally agree that the environment continues to favor higher-quality, more predictable companies with good balance sheets. Proof that whether one calls it half empty or half full, men of different minds will often drink from the same glass.

For those who sidestepped the tide of newsprint and gale of airwaves devoted to the decision, Microsoft declared its first ever dividend late Thursday. On Friday morning the market studied this purportedly historic event and listened to all the commentary on what it meant for the maturation of the tech sector and a new age of corporate governance. And then investors shrugged, and sold.

Microsoft shares gave up 7% of their value Friday, and lost $4.46 for the week to $51.46, as traders focused on the company's lack of enthusiasm about computer demand and its damping of revenue expectations in the current fiscal year.

The general dismissal of the company's slender 16-cent annual dividend reinforces a point made here several times recently, as excitement bubbled about how dividends -- which the president wants to make tax free -- could boost the stock market.

Specifically, the increased emphasis on dividends, taxable or not, is a modest, long-term net positive and may inspire companies to feed and care for their shareholders better.

But dividends, which now account for less than 2% of stock values, don't have nearly the power to drown out the daily static and whine that drives stock values -- including such little things as economic growth, profit trends, valuations and general investor sentiment toward equities. The outsized emphasis on dividends as panacea seems to indicate there's less hope to be drawn by the Wall Street establishment from those other factors.

The size of the dividend, amounting to 0.3% of Microsoft's share price at the time of the announcement, might indicate that the company is playing shareholder politics, giving the ducks what they have been quacking for lately. The company has more than 40 years worth of dividends sitting in cash at the current payout rate, hardly enough to warrant calls for a seismic shift in the cash-deployment orientation of large tech companies.

According to Soundview Technology Group, the 77 tech companies in the S&P 500 have $169 billion of cash and short-term instruments, and $70 billion of cash net of debt. Microsoft accounts for 24% of the cash and investments and 60% of the net cash. If they all followed Microsoft's example with proportional magnanimity, dispersing some 2% of cash on hand annually, that would come to another $600 million a year in the pockets of investors.

Hardly a market moving sum. Maybe even too small a dose to be a proper placebo to make investors feel much better about tech shares.

Microsoft had good company last week as a great company that nonetheless managed to disappoint investors. These are the winners of the long downturn, large, over-achieving, well-managed firms that delivered earnings as promised but struck a dissonant chord with Wall Street.

International Business Machines, Intel and General Electric also fit into this group, producing quarterly profits that met or exceeded forecasts while their executives spoke of tough going ahead.

In these cases, many an investor could mouth the cliche that ends so many affairs: "It's not you, it's me."

The companies continued to dominate their markets and strengthen their balance sheets. But investors have been expecting too much out of these blue chips and others, pricing their stocks as if a powerful thrust of earnings growth was imminent. In each case, the companies could give no such assurances, and their stocks were hurt as a result.

For Intel and IBM, as with Microsoft, the absence of a discernibly growing appetite for PCs and other computing products and services was the familiar culprit.

Yet GE, the sprawling industrial amalgam coming to grips with its new slower-growing self, is perhaps a better proxy for the corporate sector as a whole. Like American companies in general, GE is fighting against an environment of low nominal economic growth and overcapacity that saps demand and clips pricing power.

GE also has exposure to troubled financial areas via its reinsurance business, for which it took a $1.4 billion charge last quarter. Some commodity costs, like the oil needed for the plastics unit, are on the rise. And GE's gas turbine division, hurt by the ailing utility sector, is entering its long-anticipated cyclical decline.

For the whole of 2002, GE coaxed 7% earnings growth, to $1.51 a share, from a 5% revenue increase. Its outlook for this year's profits encompasses a range of $1.55 to $1.70 a share, straddling the consensus $1.62 forecast, which amounts to 3% to 13% growth. The high end of that range would not get GE to the 14% growth that's expected -- for the moment, anyway -- from S&P 500 companies in aggregate. There's the added risk in these forecasts that, for GE and stocks in general, the promised profit growth is supposed to be heavily dependent on a nice second-half economic acceleration that's scripted to arrive on cue.

Based on the current consensus 2003 profits, GE shares' P/E multiple is above 15, versus 16 to 17 for the broader market. With a likelihood of single-digit profit growth, "that doesn't leave a lot of room for multiple expansion" for GE, says one money manager who no longer owns the stock.

Which perhaps leaves GE shares, at $24.08, where the market finds itself generally. Arguably fairly valued, range-bound and subject to bouts of hope and disillusionment. One thing GE has in its favor is its dividend yield, which is above 3% a year. More than most, GE pays investors a little something to wait.

In what many agree is likely to be a trendless yet treacherous market for some time to come, tactical acuity and individual stock selection are the most effective moves for the current game. In case that sounds easy, consider the spirited analytical contests now raging among professionals who are all trying to trade smart and guess right on controversial stocks.

Apple Computer,
which reported results last week, is the subject of stark disagreement among analysts and investors, and not because of the overall weakness in PC sales. The strength of its strategy, products and financial standing are all in the eye of the beholder.

Here are the facts. Apple lost $8 million, or two cents a share, last quarter after five cents worth of restructuring and accounting charges, thus meeting the standard Wall Street forecast of three cents.

Apple is losing money selling computers at the moment. Only the interest on its ample $4 billion cash stash keeps it in the black. Declining short-term interest rates might further crimp stated earnings for fiscal '03 (ending in September), which are now expected to hit 17 cents a share.

Notebook-computer sales are going gangbusters, and two new laptops just introduced have received nice reviews from important technology critics (such as the Wall Street Journal's Walt Mossberg). Desktop sales are soft. The stock last week fell 62 cents to $14.10.

Some skeptics simply call Apple a doomed competitor that will never grab enough market share to quench its ambitions. Its retail-store strategy is risky and unproven. On a straight P/E or price-to-sales basis, the stock is quite expensive. Merrill Lynch's Michael Hillmeyer thinks Apple could trade below its cash level of $11 per share and advises investors to sell the stock.

The bulls begin with that $11 a share in net cash, which is a major buffer for a stock trading at its present level. They also mention the promising slate of products, including the laptops and the iPod digital music player.

Oddly, one bull cites Apple's swollen expense structure as a reason to like the stock. Don Young of UBS Warburg points to the increases in sales and marketing spending since 2000, when competitors began cutting back, saying, "Apple is sized for $8 billion in revenues but is a $6 billion company."

Apple, iconoclastic as ever, says it's investing for the long term. Young calculates that if 2000 expense levels were simply maintained, an extra $1 a share in earnings would surface this year. Woulda, coulda, one might say. But with $1 a share or more in earnings power, all that cash and a unique franchise, the case for the stock at $14 seems plausible.

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